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Insurance linked securities: UK Government consultation

Further to discussions between the London insurance market and HM Treasury since the publication in November 2014 of the "London Matters" report on the competitive position of the London Insurance Market, the UK Government is consulting on the development of a legal framework for the authorisation and supervision, corporate structure and taxation of vehicles designed to attract insurance linked securities (ILS) business to the UK.

The consultation document (published on 1 March 2016) sets out the Government's initial thinking in these areas and invites the views of stakeholders on a number of key questions. The period for submitting responses runs until 29 April 2016; the Government aims to produce draft regulations for a new ILS framework later this year.

This note briefly highlights some key points concerning the parameters of the consultation and the issues being consulted on.

Authorisation and supervision

The proposals at this stage have been developed with a focus on the two most common forms of ILS deal, collateralised reinsurance and CAT bonds. Views are sought as to whether this is the right initial focus and what other forms of ILS might be focused on.

The framework for authorisation and supervision of SPVs under Solvency II (S2 Requirements) forms the basis of the proposals in respect of insurance SPVs (ISPVs), including the requirements that:

the ISPV must be fully funded at all times; and

the rights of investors must be subordinated to the ISPV's obligations to cedants.

Investment in ILS securities would be restricted to knowledgeable and sophisticated investors. Views are sought on whether ILS investment should be restricted to sophisticated investors and whether a secondary trading platform will be needed to facilitate growth in UK ILS business.

Governance: a minimum of three board members for a UK ISPV are envisaged (chairman, chief executive and chief finance officer; the necessity for a chief actuary is being consulted on).

A period of 6 – 8 weeks is envisaged for authorisation of an ISPV (in the case of a relatively standard form of ILS transaction), from submission of a formal application (following optional pre-application engagement and submission of additional documentation intended to facilitate an accelerated decision on an application, including possible independent legal opinions on ISPV compliance with the S2 Requirements). Views are sought on the envisaged 6 – 8 week timeline for authorisation (and on a number of questions concerning the application process).

The Prudential Regulation Authority (PRA) aims to produce a Supervisory Statement on the authorisation process for ISPVs in the first half of 2016.

Corporate structure

With the exception of two questions about ownership arrangements, the proposals and questions in this section of the document all relate to the Government's proposal to amend UK company and insolvency laws to allow for the creation of 'protected cell companies' (PCCs) for use in ILS deals where it is intended that an ISPV will enter into multiple collateralised reinsurance transactions (an ISPV of this kind is referred to in the consultation paper as a multi-arrangement ISPV, or mISPV).

As in other jurisdictions whose laws permit similar structures, a PCC structure would involve the legal segregation within one company of pools of assets and liabilities. This would allow an individual collateralised reinsurance deal to be allocated to its own cell, such that if a PCC undertook several deals and the collateral supporting one deal were insufficient, none of the other deals would be affected (it would also allow for the cell allocated to the 'failed' deal to be dissolved without affecting any other cells or the PCC itself).

The key advantages of a PCC regime are savings in time and administrative expense as a result of not having to establish a new ISPV for each separate collateralised reinsurance contract. These efficiencies are most marked in respect of the regulatory authorisation process; it is proposed that once an mISPV had been authorised (Stage 1), additional cells (for individual deals) could be formed by way of board resolution and an individual deal could be entered into on a 'notification-and-non-objection' basis shortly after notifying the PRA of the proposed deal (Stage 2). The Government is consulting on the length of the notification period, and on whether the market thinks that significant changes in the intended use of an mISPV could occur following Stage 1 such that more flexibility might be needed at Stage 2.

A range of other issues are being consulted on regarding the proposed introduction of an ILS PCC regime, including in respect of a number of points concerning internal structure; disclosure of PCC status in dealings with third parties; allocation of non-contractual liabilities; effective segregation of assets and liabilities within PCCs; contracts between constituent parts of a PCC; insolvency arrangements in respect of individual cells and the core of a PCC; and cross border insolvency issues.

Taxation

The document notes that in view of the 'risk transforming' nature of ILS deals and the desire to attract ISPVs to locate in the UK, it will be necessary to design a tax treatment for UK ISPVs similar to that provided in offshore jurisdictions (i.e. no or minimal tax within the ISPV, with tax payable by investors in the jurisdictions where they are located on their share of the vehicle's income).

Accordingly, it is proposed that equity-backed UK ISPVs (or cells within mISPVs) would be exempt from corporation tax on profits arising within the vehicle, but that their investors would be subject to tax on the distributions they receive. The possibility of a withholding tax being levied on distributions paid to non-UK investors is raised; however it is recognised that eliminating withholding tax has been a key issue raised by stakeholders, and views are sought on the extent to which such a withholding tax could undermine the competitive value of corporation tax exemption for the ISPV.

In the case of debt-backed ISPVs, it is noted that under existing rules, interest payments to non-UK investors are subject to withholding tax and that because of linkages with other ongoing projects, updating the existing rules in this regard within the desired timeframe "would be challenging". In view of this, the Government suggests that the 'tax exemption approach' put forward for equity-backed ISPVs could also be suitable for debt-backed deals and invites views on this suggestion (and on any barriers there may be to funds being raised for collateralised reinsurance deals through debt instruments).

The London Market Group, the senior market-wide body championing the modernisation agenda in the London insurance market, has welcomed the consultation and is encouraging all interested parties to respond with their views in the hope that a bespoke framework for ILS in the UK will become law by the end of 2016.

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